Calculating tax on large payments

In this article we explain how to work out how much tax you will pay on any ex gratia settlement amount in excess of £30,000. This article is not for the faint hearted and it may be of more use to your accountant that to you directly, but here at Compromise Agreements Ltd we cater for all employees from blue collar workers to boardroom execs. If you want to find out how much your claim is worth try our free Compromise Calculator.

HMRC decided that employers must use the 0T tax code, rather than BR, from April 2011 in relation to ex gratia payments over £30,000 which are not included in your P45.This could apply if for example you are dismissed, issued with a P45, and then we negotiate a high settlement for you by way of a compromise agreement.

The regulations state that the 0T tax code is to be applied on a “non-cumulative” basis. For an employee paid on a monthly basis, this means that only 1/12th of the basic rate band (and, if relevant, 1/12th of the higher rate (40%) band) is available in the month of payment.

This will mean that if the termination (or other) payment is more than the appropriate proportion of the 20% band, the excess will be taxed under PAYE at 40%, and if the payment is also more than the available 40% band, the excess will be taxed under PAYE at 50%.

Firstly, the employer will have to operate PAYE on the basis that none of the personal allowance is available.

Secondly, “monthly” means tax, rather than calendar, months. Tax months run from the 6th of one calendar month through to the 5th of the next (as each tax year starts on 6 April). This means that payments made on, say, the 7th of one calendar month and the 2nd of the next would fall within the same tax month with the effect that only one month’s bands would be available to share between the two payments.

Finally, the change increases the risk that the amount of PAYE deducted is more than the actual income tax liability. If the employee has little other taxable income in the tax year, he could have too much PAYE deducted from the termination payment and have to reclaim some tax through his tax return.

General example

For example, the PAYE that has to be applied to any post-P45 payment in the first month of the 2011-12 tax year (month 1) will be roughly as follows:

• The first £2,916.67, or the whole payment if it is less than this amount, is taxed at 20%, which means a PAYE deduction of up to £583.33 (£2,916.67 is the 20% band for 2011-12 for month 1, found by dividing by 12 the 20% band for the year, £35,000).

• The next £9,583.33 is taxed at 40%, which means a PAYE deduction of up to £3,833.33 (£9,583.33 is the 40% band for month 1, found by dividing by 12 the 40% band for the year, £150,000 – £35,000).

• Any amount above £12,500 is taxed at 50% (£12,500 is the combined 20% and 40% bands for month 1, found by dividing £150,000 by 12).

This would mean that if, after 6 April 2011 and the issue of the P45, an ex-employee receives a termination payment:

£10,000 example

• Of £10,000, £3,416.66 would be withheld as PAYE (compared to £2,000 under the pre-6 April 2011 BR tax code).

The PAYE is calculated as follows:

2,916.67 @ 20% = 583.33

7,083.33 @ 40% = 2,833.33

• Of £20,000, £8,166.66 would be withheld as PAYE (compared to £4,000 under the pre-6 April 2011 BR tax code).

The PAYE is calculated as follows:

2,916.67 @ 20% = 583.33

9,583.33 @ 40% = 3,833.33

7,500 @ 50% = 3,750

The practical impact of this change is that, from 6 April 2011, it will no longer be the case that a cash-flow advantage will generally arise from making payments after issuing the P45. Instead, the relative merits (from a cash-flow perspective) of pre- or post-P45 payment will need to be assessed individually in each case.

Possible advantages to the change

If an employer makes more than one post-P45 payment to an employee in a tax year, each separate payment will be subject to PAYE independently, and it will not take account of the earlier payments when working out PAYE on the later payments (each payment is treated as if it was paid in month 1 of the 2011-12 tax year, and so this is often called the “month 1 basis” by tax professionals).

However, the key date is when the employee becomes entitled to the amount: simply delaying payment of portions of an amount to which the employee is already absolutely entitled will probably make matters worse as the employer will have to account for PAYE on the full amount on the date of entitlement.

This appears to mean that if a termination payment is paid in a series of monthly instalments then each instalment would be treated in the way described above, and so could be brought (at least in part) within the monthly non-cumulative 20% band (or 20% and 40% bands).

In addition, there may be a cash-flow advantage for an additional rate taxpayer, who does not get a personal allowance in any event and who is likely to suffer tax on a pre-P45 termination payment entirely at the additional rate (assuming that in the tax month of payment, the employee has already received salary payments that has used up the basic and higher rate allowance).

If the payment is made in a subsequent tax month, and following the P45, an additional rate taxpayer will get another chunk of basic rate and higher rate allowance because of the 0T calculation, and this won’t be reversed until he completes his self-assessment tax return for the relevant tax year.

We have specialist accountants who will be able to structure your package in the most efficient way, so if you have any questions on the tax implications of a Compromise Agreement or any other query, don’t hesitate to call us on 0800 533 5134, fill out the message box to the right hand side, or email info@compromiseagree.com